Market Volatility Moving Forward?
The FT's lex column has a small but telling synopsis on market volatility and especially whether we should expect more of it as we go forward with a slowing US economy. Lex begins by citing a BIS study which notes that volatility in fact has been quite low for the past three years.
According to a recent study by the Bank for International Settlements, volatility from mid-2004 to March 2006 was notable because it was low for a prolonged period, simultaneously, across different assets in both industrial countries and emerging market economies. The BIS believes part of the reduction is structural.
However this, I think, might well be about to change. The overall point is that conventional wisdom these days are being revised by the hour as suggestions of whether global interest rates might have peaked or not go hand in hand with whether headline inflation will spillover into core inflation. In fact, I am banging my head on this one at the moment. Globalization has surely held core inflation down but also raised the headline measure; if this is the highest level of interest rates we can expect from the Fed, ECB and BOJ going forward, what are we going to see then? Stagflation seems a real possibility in the US.
'I thought the classical discourse on this was that it would keep inflation up because of all those commodities increasing in price.'
Clearly this is part of the story but only a part since there is also a reverse effect contained in the same set of dynamics producing the inflation spike in commodites and assets.
. In the recent print edition The Economist has an interesting article (Hat tip New Economist) which attacks this issue albeit from a different perspective; namely the Phillips Curve. The magazine points to a flattening of the curve ...
'A flatter Phillips curve is good news when unemployment is falling. But it also implies bad news if inflation rises significantly. It would then take a much larger increase in unemployment (a more severe recession) to bring inflation down again. This may explain why the European Central Bank has found it so difficult to get euro-zone inflation back below its target of 2%.'
The Economist also points to this which has also been articulated by Kenneth Rogoff.
'The Federal Reserve may focus on the low core rate of inflation but workers may be watching the headline numbers, which in most countries have been significantly higher. The sharp drop in oil prices in recent weeks may reduce this differential, but could easily be reversed by supply disruption or a harsh winter.
If workers begin to focus on the effect of higher commodity prices on their spending power, and regard the effect as permanent rather than temporary, then they may push up their wage demands. That could lock higher inflation into the system, giving central banks a devil of a job to bring it back down again.'
So a preliminary conclusion here would go something like this:
Since it now seems that the US economy, the Eurozone and Japan all are facing a slowdown the risk as articulated by recent posts in blogland this might very well turn into stagflation, at least if we follow this from a theoretical point of view. However, the first very important point here in terms of the global economy is to distinguish between the US economy on the one side and The Euro and Japanese economy on the other side. As such the argument above derived from The Economist's article might end up fitting the US but not in the Eurozone (some countries!) and Japan where population dynamics make the risk for deflation higher mainly due to fiscal tightening in the immediate horizon. In terms of the US and the idea of stagflation especially Nouriel Roubini seems to think this is a real probability particularly if expectations begin to adjust to headline in stead of core inflation.
I am not, to say the least, sure about this analysis. I feel that it contains the right components but perhaps they are not rightly macthed?